Getting the Valuation Correct

Morningstar’s Fair Value Method

It is the Morningstar analyst’s estimate of what the stock is worth. The Fair Value Estimate should be used in conjunction with our Economic Moat rating and our Business Risk rating.

Doesn’t tell you much.

But from what I can gather based on testing various inputs and the results I’m getting, it looks to be an internal DCF model with growth estimates based on analyst numbers.

I could be completely wrong but as I try to reverse engineer their fair values, it does feel very close.

Since a DCF is industry standard, I’m just starting with the DCF calculator, starting off with an assumed FCF, using a 9% discount rate and then playing around with the growth rates to get a value that matches their fair value.

Then I compare the final growth rate I’m seeing with the consensus analyst growth rate.

The results are fairly close. You’d be surprised that despite how firms say that they have a proprietary model, it’s doesn’t differ much from a 2 or 3 stage DCF.

After writing all this, I found an article which explains Morningstar’s method of valuing stocks which is exactly I expected.

But before I continue, click on the image below to be a VIP and get all the hidden content and exclusive resources we don’t publish anywhere else.

Old School Value’s Fair Value Method

I have two philosophies when it comes to valuing stocks.

Keep it transparent

Master multiple valuation methods and use the correct one for the situation

Sure, there’s no need to disclose what stocks you hold and how much you own, but when it comes to valuing stocks and performing analysis, there’s no reason to hide behind a black veil of secrecy.

No matter how good a valuation technique is, it’s never 100% accurate.

And if it’s not 100% accurate, why bother trying to keep something that doesn’t work all the time a secret?

Since I want to compare my estimates with that of Morningstar’s on 5 stocks that caught my eye, my fair value estimates are the averages of the DCF, Graham’s Formula, EBIT Mulitples and Absolute PE valuation method.

I keep all models transparent so that you can see everything from how it’s built, what the inputs are and even adjust the formulas yourself.

How to Apply a Moat Rating To Your Thesis

I’ve always liked how Morningstar displays their information, and their moat system is just one of them.

One quick way I measure moats is by comparing the Net Reproduction Value with the Earnings Power Value that Bruce Greenwald teaches in his value investing class at Colombia University.

Using EPV to Determine Moat | Enlarge

I do the same thing in the OSV analyzer.

Book value, the net reproduction value and the EPV are compared to determine whether the company has a moat or not.

A wide moat is a company where the EPV is much higher than the net reproduction value.

A narrow moat is where the EPV is only slightly higher than the net reproduction value.

No moat is where the EPV and net reproduction value are equal.

A value destroyer is where the EPV is less than the net reproduction value.

In this example, a moat clearly exists, but it’s not as high as it used to be.

Determine the Moat with the EPV Chart

The chart is for IBM by the way. A year ago, the EPV was much higher, so it’s an indication that IBM’s moat is eroding slowly.

Compare it to this chart.

Wide Moat Shown Through EPV

The EPV is shooting through the roof here.

This is what you call a moat.

The company is Western Union (WU).

Now this is just one way of coming up with a moat. You could follow a more qualitative process of reading through reports, books, newspapers and getting a better understanding of the entire company and industry.

Then either grading it an A to F or draw up a neat spider chart, which happens to be my method of choice.

IBM Moat Spider Chart

The bigger the surface area, the bigger the moat, and better the investment.

Compare it to the many companies that look like this.

Fast Growing Companies with No Moat Look like This

Get creative with how you want to represent your moat.

But try to keep it simple so that a single glance can tell the entire story.

Revenues have been falling and the bears have been saying that IBM is more focused on financial engineering to provide good numbers instead of being innovative and growing.

Previously, I’ve valued IBM at $200 but I’ve had to scale it back because the financials do show a slowdown.

IBM is still has cash cow and buying back shares is never a bad thing.

After all, look at what PRLS did. The CEO practically bought back ALL the shares of the company. I don’t consider buying back shares financial engineering to inflate EPS because the market isn’t that stupid.

Maybe it would have passed 30 years ago, but not today.

Again, the question with these stocks is, why are they cheap?

Try this Exercise if You Want to Get Better

With all the information you have about calculating intrinsic value, moats and uncertainty ratings, I recommend that you try this as a case study.

Value these stocks on your own and come up with your own moat rating.

Then see how it unfolds a year or two later and scrutinize what you did right/wrong.

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